The financial crisis and recession took a heavy toll on the sector: The investment environment was so severe in 2008 that nearly 700 hedge funds closed in the first three quarters.
The investment advantage of hedge funds is that they use their borrowing capacity as leverage to increase their ability to make investments, but this advantage is can also become their Achilles' heel. If their investments falter, their ability to pay back what they have borrowed is often limited. The funds' high level of leverage also threatens banks, because they are usually the sources of the borrowed capital.
Excessive leverage was, in the minds of many analysts, one of the key triggers of the financial crisis. Bankers would argue that their balance sheets are stronger than they were in 2008, when they held tens of billions of dollars in mortgage-backed paper. That improvement will not keep bank earnings from suffering if bets by some hedge funds do not play out and financial firms are unable to recover the large amounts of money they loaned to them.